Time to Fail

"The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming …”

-Theodore Roosevelt

I’ll admit that my peak athletic days are behind me. At my best, I was a middling college hockey defenseman with a propensity for extended stays in the penalty box. My worst probably came last night in a beer league hockey game in Hamden, CT. Nonetheless, my hometown of Bassano, Alberta has invited me back to speak at the annual Sportsmen of the Year Dinner, so my athleticism is, apparently, still appreciated somewhere.

In a shift of athletic gears, this summer I joined the New Haven Lawn Club and officially began my tennis career. Certainly I’ve played tennis before, but not on clay courts attired completely in whites. As many of you know, tennis clubs are typically populated by people that have spent a good chunk of their lives, well, populating tennis clubs. Needless to say, this Alberta farm boy was a little overmatched this summer. In fact, my summer was spent failing and, often, miserably so.

Personally, I’ve never believed failure to be a bad thing. Now sure, losing or failing doesn’t give you the warm fuzzies inside, but failing and adapting ultimately sets you up for greater success. In a 2008 commencement address to Harvard, author J.K. Rowling, who made a billion dollars for her Harry Potter series, adroitly summed up the benefits of failing when she said:

“So why do I talk about the benefits of failure? Simply because failure meant a stripping away of the inessential. I stopped pretending to myself that I was anything other than what I was, and began to direct all my energy into finishing the only work that mattered to me.”

As it relates to Europe sovereign debt, the one solution that has not been seriously considered is failure. Instead, the key solution from almost every Eurocrat and talking head, is to continue to support and promote a broken banking system and failed monetary union. There are other possibilities: let Greece fail, let other sovereigns fail if they can’t get their house in order, and let heavily exposed banks fail.

The validation of the failure strategy at least partially comes in comparing the credit default swaps of Italy, Portugal and Ireland from July 1st, 2011 to today. Respectively, Italian swaps are up 140%, Portuguese up 38.2%, and Irish down -3.2%. Now to be fair, Ireland hasn’t failed, but three of largest banks, Allied Irish, Irish Life & Permanent, and Bank of Ireland have experienced “credit events” and, as a result, Ireland’s credit worthiness has improved, on the margin.

A more pressing question facing stock market operators is: will this current stock market rally fail? In the near term, the key driver of the stock market will likely be corporate earnings reports. To sustain positive price momentum, companies will need to both hit their estimates and also maintain future guidance. Currently, according to Bloomberg consensus estimates, 2012 consensus expectations for EPS for the SP500 is $106.15, which implies 16% year-over-year growth in earnings.

Certainly, that type of earnings growth is possible for the SP500, but it is highly contingent on underlying economic growth. Currently, our view is the economic growth will be in the sub-1.0% range in 2012. In the last thirty years, there have been five years of 1%, or less, GDP growth in the U.S. On average, in those years, SP500 earnings declined -18.3% y-o-y. Thus, unless economic activity accelerates in the U.S., it is highly unlikely that 16% y-o-y growth in earnings is met. Assuming the Hedgeye view of economic growth is correct, there is substantial downside to current 2012 consensus earnings estimates. History would suggest, as outlined above, that 2012 earnings could be too high by at least one-third.

Alongside earnings growth, there is of course the quality of earnings. J.P. Morgan kicked off the earnings debate this morning with an EPS number of $1.02 that, at first blush, seems solidly above consensus of $0.92. The questions as always, though, relates to the quality of earnings, and $0.29 of EPS was a “benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads.” So, if we back out the benefit to JPM’s earnings from widening of their credit spreads, EPS declined -27% year-over-year. Yikes !

The more pressing failure in global macro land this morning is the failure of the Chinese to maintain high exports to Europe. To be fair, in aggregate Chinese exports overall were up 17.1% in September, which is a formidable number. Unfortunately, exports to Europe, Chinese largest trading partner, declined substantially, sequentially from 22% year-over-year in August to 9.8% in September. As the Chart of the Day below shows, this is the second slowest year-over-year growth rate of Chinese exports to Europe in 18+ months.

Chinese economic activity is clearly slowing, but in our purview it is still too early to call for massive Chinese easing. As my colleague Darius Dale wrote yesterday:

“All things considered, it could be a while before China pulls the trigger on the monetary easing front. Merely using 2008 as a semi-comparable reference, we saw that China waited a full six months for confirmation of flat-to-down sequential CPI growth and a -380bps reduction in YoY CPI before cutting interest rates in early September of that year.”

Certainly though, growth doesn’t slow forever and whether by monetary stimulus or organic means, the positive catalyst we will be looking for is growth accelerating, on the margin. So far though, it is too early to bet on that.

Keep your head up and stick on the ice,

Daryl G. Jones

Director of Research

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10/13/11 08:02 AM EDT

THE HBM: TSN, SBUX, PZZA, DIN, DRI, BWLD

THE HEDGEYE BREAKFAST MONITOR

MACRO NOTES

Commodities

Upwardly revised grain stockpiles estimates in the US are driving corn and wheat prices lower this morning.

SBUX: Starbucks announced yesterday the availability of its Via Ready Brew in House Blend and Breakfast Blend at select grocery stores across the US.

SBUX: According to the blog “Starbucks Gossip”, “The super big announcement that is going down is about whole bean coffee and how the categories are going to change. Starbucks is going to offer three different categories -- "blonde," mild and dark roasts. There will now be two new coffees offered that are milder than Breakfast Blend. I believe the new category system and new coffee offerings are going to start late this year with an official launch in January 2012.”

HEDGEYE - While this may be gossip, it makes sense now that SBUX controls its distribution channel for the company to continue with new product innovation.

SBUX: In an interview yesterday, CEO Howard Schultz says Brazil and China are emerging markets where Starbucks has too few stores.

GMCR traded down on significantly higher volume during yesterday’s trading.

CASUAL DINING

DIN: Dine Equity has announced the sale of 17 Applebee’s from which it expects net proceeds of $15.9m. DIN has sold 259 restaurants since buying Applebee’s in November 2007.

DRI: Darden is to add Eddie V’s Prime Seafood and Wildfish Seafood Grille to its specialty restaurant group, according to the WSJ. The acquisition of 11 locations cost Darden $59M in cash and the deal will, according to the company, be neutral to its fiscal earnings.

Insecurity's Ego

This note was originally published
at 8am on October 10, 2011.
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“I love playing ego and insecurity combined.”

-Jim Carrey

There is a good article in this week’s The Economist titled “Return to Maastricht” where Charlamagne interviews locals in the Dutch town that gave birth to the Euro in 1991. Frans Timmermans has a concise quote on page 68 that summarizes the Eurozone today:

“Europe seems to be an agent of insecurity. The benefits are invisible; the downside is very visible indeed.”

The French know this. The Belgians know this. The Germans and the Dutch know it too – but the question remains as to whether or not they need to swallow Bear Stearns like exposures whole to the extent that the French and Belgians do.

On that score, this morning’s #1 Most Read Story on Bloomberg tells you all you need to know about what matters to interconnected Global Macro markets today:

“Merkel, Sarkozy Pledge Bank Recapitalization”

And while there are very different definitions of the size and scope of this “recapitalization” (coined first at Hedgeye as the Eurocrat Bazooka), this morning’s Global Macro market action tells you all you need to know about dominos.

Dexia, as we wrote last week, is the domino.

Dexia is a Belgian/French bank that is being bailed out this morning by, drum-roll, Belgium and France. Sure, the fine lads in Luxembourg appear to be throwing in some Europig Paper too – but, ultimately, this is a Belgian and French thing. A really big thing for those 2 countries in particular (relative to Germany and the Netherlands), because Belgium and France have marked their Pig Paper at par!

Qu’est ce qui se passe avec le marking of le Pig Paper at par?

Put simply, this is what Bear, Lehman, Morgan, etc. did in 2007-2008. They called it “level 3 asset pricing.” And Bailout Bankers around the world can call it whatever they want in Europe this morning, but there is one thing it is not – marked-to-market!

The most important move in all of Global Macro for the past 3 weeks has been that the US Dollar Index has been up for 3 consecutive weeks. In the end, I think this is the most bullish development there has been for the US economy. Strong Dollar = Strong America.

With the US Dollar Index up +7.8% since La Bernank tested Burning The Buck to a 30-year low in April of 2011, this has been good for the 71% of America that matters – Consumption (C) as a % of US GDP – and bad for dysfunctional debtors who are begging for bailouts.

This isn’t a consensus view. But I’m not really a consensus kind of a guy. And neither should you be. If the last 3 years has taught you anything about common sense, one is that Keynesianism is not for the commoner. If you are a debt laden aristocrat, sorry – can’t help.

Of course the US Dollar strengthening has nothing to do with Ben Bernanke or Tim Geithner changing their Keynesian policies (yes, It’s The Policy, Stupid). It has everything to do with the Europeans trying to do exactly what our Too Big To Perform financial system had Americans do in 2008 – bailout bad banks with tax payer backed fiat currency.

Perversely, with the “news” of the Dexia Domino in motion this morning, the Euro is rallying to another lower short-term and lower long-term high. This has more to do with the mechanics of the EUR/USD pair being the most widely held short position on planet hedge fund right now, so don’t let it stress you out.

Across all 3 of our risk management durations (TRADE, TREND, and TAIL), the Euro (versus the USD) remains bearish/broken:

TRADE resistance = $1.36

TREND resistance = $1.42

TAIL resistance = $1.39

When all 3 of our risk management durations are bearish/broken, we call this a Bearish Formation. Those are not good.

And neither is Austria or Greece seeing their stock markets get hammered for -4.5% moves to the downside this morning. I guess that’s what you get when your Eurocrat Bazooka isn’t big enough, yet. Size matters. Insolvent European banks are seeing their marked-to-market stock prices fail. Insecurity’s Ego is going to have to have another European emergency bailout meeting about that…

My immediate-term support and resistance ranges for Gold, Oil, the German DAX, and the SP500 are now $1604-1676, $80.66-84.66, 5429-5830, and 1145-1169, respectively. My Cash position in the Hedgeye Asset Allocation Model dropped to 64% from 73% week-over-week.

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THE M3: TAM COMMENTS

Secretary Tam said Macau’s economy is expected to maintain a “low double-digit” growth this year. Tourism business during Golden Week this year was “better than expected,” Tam said.

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10/13/11 07:01 AM EDT

THE HEDGEYE DAILY OUTLOOK

THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - October 13, 2011

After a serious short squeeze (and 2011 has had many), we’re back to the Global Macro fundamentals this morn, and they are not good looking at China, Copper and the Euro. Today, JPM earnings are what matters most. If Jamie Dimon tells the truth about his interconnected exposures from FX, to NIM, and counterparty risk in Europe, yesterday’s selloff into the close will make sense. If he says everything is fine, SP500 can suspend disbelief to 1229.

As we look at today’s set up for the S&P 500, the range is 58 points or -3.25% downside to 1168 and 1.55% upside to 1226.

DuPont is seeking buyers for a polyester-film joint entire and a business that makes powder-based paint.

RIMM said customers in Canada and U.S. still face delays to its Blackberry network.

Galleon’s Raj Rajaratnam will be sentenced today for masterminding the biggest hedge-fund insider trading scheme in U.S. history.

COMMODITY/GROWTH EXPECTATION

COPPER – The Hedgeye TRADE/TREND/TAIL lines are all overhead with immediate-term TRADE resistance closest at 3.59/lb and no legitimate support until 3.01/lb; this recent gap up on no volume looks like a very dangerous air-pocket (like most thing equities and commodities do)

MOST POPULAR COMMODITY HEADLINES FROM BLOOMBERG:

Congress Approves Biggest U.S. Free-Trade Agreement Since 1994

Australians Fret About Crash With Fortescue Metals Growth Stock

Thai Flooding Threatens Bangkok, May Cut Deeper Into Growth

Coal to Drop in Asia After 2011 ‘Perfect Storm’: Energy Markets

Zinc Bear Market Seen Ending as China Absorbs Glut: Commodities

Oil Falls a Second Day on Speculation U.S., China Demand to Slow

Clive Fund Said to Erase Year’s Loss With 11.4% September Gain

Best Mining Deal Seen With Sundance China-Africa Ties: Real M&A

China Copper Imports Gain to 16-Month High as Price Tumbles

China Copper Stocks at Record 1.9 Million Tons at End-2010

Codelco Plans Anglo American Option After $6.75 Billion Loan

Rice Farmers in Japan Set Tougher Radiation Limits for Crops

Gold Falls in London Trading as Dollar’s Rebound May Curb Demand

China’s September Foreign Trade by Commodity (Table)

Copper Declines After Rally to Two-Week High Seen as Excessive

Copper Falls in London After China’s Exports Cool: LME Preview

COMMODITIES DAYBOOK: Oil Slides on Demand Concern; Copper Drops

Gold Eclipses Cocaine as Rebels Tap Colombian Mining Wealth

CURRENCIES

EURO – understanding that this is one of the largest short positions left in the hedge fund community, yesterday’s attempts to scare the shorts really only did one thing - open the gap on the downside to 1.30 now – in other words, it should be considered probable that that could happen over the span of 1-3 days. Yes, that would be bad

EUROPEAN MARKETS

SLOVAKIA: Slovak parties reached an agreement to approve Europe’s enhanced bailout fund, paving the way for a second vote this week that will complete its ratification process across the 17 euro countries. A second vote will be held on the European Financial Stability Facility tomorrow or on Oct. 14 after lawmakers failed to approve the legislation yesterday, Robert Fico, head of the largest opposition party Smer, said today. Party leaders agreed on elections to be held on March 10, he said.

ASIAN MARKETS

CHINA – reported a bomb of an export report for the mth of SEP this morning showing a drawdown to +9.8% exports to Europe vs +22% in August; this is why the Chinese and HK stock markets (or any market in Asia for that matter other than Indonesia who cut rates this wk) remain in Bearish Formations; it tells you most of what you need to know on why Copper is still in crash mode too (down -1.3% this morn)

Add Singapore to the list of Asian economies that have introduced or implemented policy focused specifically on boosting domestic demand in recent months. This is a trend we’re seeing across developing Asia (China, Singapore, Indonesia, Thailand, Philippines, Malaysia thus far) and will eventually be bullish for their equity markets – especially given that they have the fiscal space to implement such policies (whereas the U.S./E.U./Japan remain largely constrained by large deficits and debt burdens).

MIDDLE EAST

Howard Penney

Managing Director

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10/12/11 05:14 PM EDT

Checking In With China

Conclusion: We recommend both caution and patience to those using [potential] Chinese stimulus as their bullish catalyst for equities or commodities at the current juncture. Moreover, we think that, if eventually signed into law, Chuck Schumer and Sherrod Brown’s trade legislation is likely to leave the U.S. economy worse off.

China Won’t Bail Consensus Out At These Prices

A lot of speculation is bouncing around the halls of consensus about Chinese stimulus potentially providing a positive force for the global economy. We’d be cautious to fade that – for now. Yes, China relaxing monetary and fiscal policy would indeed be very bullish for the Chinese economy and very supportive for the global demand curve, but getting from point A to point B could wind up being quite painful.

We’ve been calling for China to eventually shift to a stance of marginal dovishness in the latter half of this year and eventually cut rates as inflation slows closer to the government’s 4% target – which, according to our models, could be sometime in 1Q12. This outlook is supported by our continued conviction in our Deflating the Inflation thesis – an explicit call to short/sell commodities – as well as conviction in our soon-to-be released King Dollar thesis, which extends that call into 4Q11.

As we've pointed out in our recent research on China, there are a number of things China has introduced or implemented on the fiscal and financial policy fronts that will be supportive to Chinese consumption growth in 4Q and beyond (email us for the most recent analysis). These are, however, not nearly as supportive as rate cuts would be to ease the credit crunch many Chinese corporations are facing. Monetary easing would also go a long way towards easing the liquidity headwinds currently squeezing Chinese property developers; at ~48%, fixed asset investment is nearly half of Chinese GDP, so it’s rather important for global growth and commodity prices. And given the credit quality headwinds facing China’s banking system, we think it is unlikely they pursue a large-scale fiscal stimulus/credit extension program like the CNY4 trillion package introduced in November ’08 – a full four months before the S&P 500 bottomed!

All things considered, it could be a while before China pulls the trigger on the monetary easing front. Merely using 2008 as a semi-comparable reference, we saw that China waited a full six months for confirmation of flat-to-down sequential CPI growth and a -380bps reduction in YoY CPI before cutting interest rates in early September of that year. We’re not quite there yet and we don’t reckon we’ll get there absent seeing the deflationary forces we’ve been calling for continue to exert downward pressure on the commodity complex over the intermediate term. And as the math continues to tell us, that outcome is likely not positive for equities in the short term (the trailing 3yr positive correlation between the S&P 500 and the CRB Index has an r² of 0.86). Eventually, deflated commodity prices will be a bullish catalyst – particularly for global consumer stocks. Eventually.

Needless to say, we recommend both caution and patience to those using [potential] Chinese stimulus as their bullish catalyst for equities or commodities at the current juncture.

Chuck Schumer Doesn’t Get It

Much to-do is being made about the passage of S-1619, the [slightly] bi-partisan bill recently introduced by Senators Chuck Schumer (D-NY) and Sherrod Brown (D-OH). The bill, which now moves on to the Republican-controlled House Ways and Means Committee, is anticipated by some to fizzle out in the House; this is crucial because all U.S. trade legislation is controlled within this chamber. The intra-party debate between Dave Camp (R-MI), who voted for similar legislation last year, and the duo of House Speaker John Boehner (R-OH) and House Majority Leader Eric Cantor (R-VA) should indeed create a spirited internal battle over the legislation.

As it stands now, the bill, if signed into law, would allow U.S. companies to seek duties on imported goods after the Treasury Department identifies whether a particular currency is undervalued. Such non-compliant regimes (i.e. "China", as argued by the bills supporters) would face dumping duties and/or a ban on federal procurement within the U.S.

Critics of the bill – including the Peterson Institute, the U.S. Chamber of Commerce, the National Retail Federation, the Financial Services Roundtable, and over 50 other business groups – claim that even if passed, it won’t have a “substantive effect” on U.S. companies due to the long lag time between filing complaints, government action, and economic results. In addition, they mock it for its “pro-U.S. jobs” claim, saying retaliatory action by China is perhaps a greater price to pay than what is currently perceived as being paid for doing business with the Chinese.

We think this bill reeks of the recent spate of misguided dogma that D.C. continues to force upon the domestic and global economy. As the title implies, Schumer doesn’t get it. Passage and implementation of this legislation would likely be very detrimental to U.S. corporations and consumers in the form of import price inflation and a closing of the Chinese domestic market to U.S. exporters – a key growth market for U.S. multinational corporations like YUM, MCD, and WMT. Remember, China can always turn to the Germans for products in the event the U.S. forces itself out of this important market. Recently, the PBOC issued on their website a stern rebuke supporting our view:

“Passage of the legislation may lead to a trade war that we don’t want to see… The [legislation] won’t solve U.S. problems of insufficient savings, a trade deficit, and an elevated jobless rate.”

Moreover, expedited yuan revaluation is especially punitive in the short-to-intermediate term as production capacity isn’t easily moved. For example in 1Q11, COH said that it would take four years to shift production from China to Vietnam. In the meantime, companies will have to incur both rising CapEx expenses resulting from expanding capacity into other low-cost countries and higher import costs in the interim from any resultant yuan appreciation.

As a courtesy "newsflash" to Chuck Schumer, it’s worth reminding him that U.S. labor costs are too exorbitant to economically manufacture footwear, apparel, and other consumables on a large scale. As such, we’re not sure how they come up with their "2.8 million U.S. jobs stolen by China” estimate. Moreover, the resultant capacity constraint on the global supply of low-cost, working-age labor could be very inflationary/really bad for margins for corporations all over the world. It’s worth noting that China has a larger working-age population than the next two largest non-U.S. countries combined (India and Indonesia).

Net-net, we think that, if eventually signed into law, Chuck Schumer and Sherrod Brown’s legislation is likely to leave the U.S. economy worse off over the short, medium, and long terms.

Darius Dale

Analyst

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